Download Chapter 11: General Equilibrium and the Efficiency of

Firm and Household Decisions
• Input and output
markets cannot be
considered
separately or as if
they operated
independently.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Partial Equilibrium Analysis
• Partial equilibrium analysis is
the process of examining the
equilibrium conditions in
individual markets, and for
households and firms,
separately.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
General Equilibrium
• General equilibrium is the
condition that exists when all
markets in an economy are in
simultaneous equilibrium.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Efficiency
• In judging the performance of an
economic system, two criteria used
are efficiency and equity (fairness).
• Efficiency is the condition in
which the economy is producing
what people want at the least
possible cost.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
General Equilibrium Analysis
• To examine the move from partial to
general equilibrium analysis we will
consider the impact of:
• a major technological advance, and
• a shift in consumer preferences.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Cost-Saving Technological Change
• Technology improvements made it possible to
produce at lower costs in the calculator industry.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Cost-Saving Technological Change
• As new firms entered the industry and existing firms
expanded, output rose and market prices dropped.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Cost-Saving Technological Change
• A significant technological change in
a single market affects many
markets:
• Households must adjust to changing
prices
• Labor reacts to new skill requirements
and is reallocated across markets
• Capital is also reallocated
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
A Shift in Consumer Preferences
• To examine the effects of a change in one market on other
markets, we will consider the wine industry in the 1970s.
Production and Consumption of Wine in the United States, 1965–1980
YEAR
U.S.
PRODUCTION
(MILLIONS OF
GALLONS)
IMPORTS
(MILLIONS OF
GALLONS)
TOTAL
(MILLIONS OF
GALLONS)
1965
565
10
575
1.32
1970
713
22
735
1.52
1975
782
40
822
1.96
1980
983
91
1073
2.02
Percent change,
1965–1980
+ 74.0
+810.0
+
86.6
CONSUMPTION
PER CAPITA
(GALLONS)
+53.0
Source: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States, 1985, Table 1364, p. 765.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Adjustment in an Economy
with Two Sectors
• This graph shows the
initial equilibrium in an
economy with two
sectors—wine (X) and
other goods (Y)—prior
to a change in
consumer preferences.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Adjustment in an Economy
with Two Sectors
• A change in consumer
preferences causes an
increase in the demand
for wine, and,
consequently, a
decrease in the demand
for other goods.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Adjustment in an Economy
with Two Sectors
• A higher price creates a
profit opportunity in
sector X.
• Simultaneously, lower
prices result in losses in
industry Y.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Adjustment in an Economy
with Two Sectors
• As new firms enter
industry X and existing
firms expand, output
rises and market prices
drop. Excess profits
are eliminated.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Adjustment in an Economy
with Two Sectors
• As new firms exit
industry Y, market price
rises and losses are
eliminated.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Wine Production is an
Increasing-Cost Industry
Land in Grape Production in the United States and in California Alone,
1974 and 1982
NUMBER OF VINEYARDS
NUMBER OF ACRES
United States
1974
14,208
712,804
1982
24,982
874,996
Percent change
+75.8
+22.8
California
1974
8,333
607,011
1982
10,481
756,720
Percent change
+25.8
+24.7
Source: U.S. Department of Commerce, Bureau of the Census, Census of Agriculture (1974 and 1982), 1, part 51.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Formal Proof of a
General Competitive Equilibrium
• This section explains why perfect
competition is efficient in dividing scarce
resources among alternative uses.
• If the assumptions of a perfectly
competitive economic system hold, the
economy will produce an efficient
allocation of resources.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Efficiency of Perfect Competition
•
The three basic questions in a
competitive economy are:
1. What will be produced? What
determines the final mix of output?
2. How will it be produced? How do
capital, labor, and land get divided up
among firms?
3. Who will get what is produced? What
is the distribution of output among
consuming households?
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Efficiency of Perfect Competition
•
As we will see, in a perfectly
competitive economic system:
1. resources are allocated among firms
efficiently,
2. final products are distributed among
households efficiently, and
3. the system produces the things that
people want.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Pareto Efficiency
• Pareto efficiency, or Pareto
optimality, is a condition in which no
change is possible that will make some
members of society better off without
making some other members of society
worse off.
• This very precise concept of efficiency
is known as allocative efficiency.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Efficiency of Perfect Competition
Efficient Allocation of Resources:
• Perfectly competitive firms have incentives
to use the best available technology.
• With a full knowledge of existing
technologies, firms will choose the
technology that produces the output they
want at the least cost.
• Each firm uses inputs such that MRPL = PL.
The marginal value of each input to each
firm is just equal to its market price.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Efficiency of Perfect Competition
Efficient Distribution of Outputs Among
Households:
• Within the constraints imposed by income
and wealth, households are free to choose
among all the goods and services available
in output markets. Utility value is revealed in
market behavior.
• As long as everyone shops freely in the
same markets, no redistribution of final
outputs among people will make them better
off.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Efficiency of Perfect Competition
Producing What People
Want—the Efficient Mix of
Output:
• Society will produce the
efficient mix of output if all
firms equate price and
marginal cost.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Key Efficiency Condition: Price
Equals Marginal Cost
X
If PX < MCX, society gains value by producing less X
If PX > MCX, society gains value by producing more
The value placed on
good X by society
through the market, or
the social value of a
marginal unit of X.
© 2002 Prentice Hall Business Publishing
Market-determined value of
resources needed to produce a
marginal unit of X. MCX is equal
to the opportunity cost of those
resources: lost production of other
goods or the value of the resources
left unemployed (leisure, vacant
land, etc).
Principles of Economics, 6/e
Karl Case, Ray Fair
Efficiency in Perfect Competition
• Efficiency in perfect competition follows from a weighing of values by
both households and firms.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Sources of Market Failure
• Market failure occurs when resources
are misallocated, or allocated
inefficiently. The result is waste or lost
value. Evidence of market failure is
revealed by the existence of:
• Imperfect markets
• Public goods
• Externalities
• Imperfect information
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Imperfect Markets
• Imperfect competition is an industry in
which single firms have some control
over price and competition.
• Imperfectly competitive industries give
rise to an inefficient allocation of
resources.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Imperfect Markets
• Monopoly is an industry composed
of only one firm that produces a
product for which there are no close
substitutes and in which significant
barriers exist to prevent new firms
from entering the industry.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Imperfect Markets
• In all imperfectly competitive industries,
output is lower—the product is
underproduced—and price is higher
than it would be under perfect
competition.
• The equilibrium condition P = MC does not
hold, and the system does not produce the
most efficient product mix.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Public Goods
• Public goods, or social goods are
goods and services that bestow
collective benefits on members of
society.
• Generally, no one can be excluded from
enjoying their benefits. The classic
example is national defense.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Public Goods
• Private goods are products produced
by firms for sale to individual
households.
• Private provision of public goods fails. A
completely laissez-faire market will not
produce everything that all members of a
society might want. Citizens must band
together to ensure that desired public
goods are produced, and this is generally
accomplished through government
spending financed by taxes.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Externalities
• An externality is a cost or benefit
resulting from some activity or
transaction that is imposed or bestowed
on parties outside the activity or
transaction.
• The market does not always force
consideration of all the costs and benefits
of decisions. Yet for an economy to
achieve an efficient allocation of resources,
all costs and benefits must be weighed.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Imperfect Information
• Imperfect information is the absence
of full knowledge concerning product
characteristics, available prices, and so
forth.
• The absence of full information can lead to
transactions that are ultimately
disadvantageous.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair